OPTELECOM INC - 10-K Annual Report

Optelecom, Inc. is a Delaware corporation whose business activities began in 1972. Optelecom’s early business commenced with the design and delivery of specialized laser systems and fiber optic communications products for the defense arm of the Federal government. During the mid-1990’s we successfully transitioned from having a significant number of military customers to being an industry provider of copper and fiber optic based communications products for commercial and government customers. We have focused on providing integrated multi-media products for communicating video, audio, and other data over both copper wire and optical network systems.

Optelecom currently manages its operations under two business segments: the Communication Products Division (CPD) and the Electro-optics Technology unit (EO). The Communication Products Division is focused on the development, manufacture and sale of optical fiber-based data communication equipment to both commercial and Government clients. The Electro-optics Technology unit develops and manufactures innovative optical devices under contract, primarily to government and defense industry customers.

Fiber optic communications equipment is the main element of Optelecom’s product offerings. The marketplace served by Optelecom is experiencing a period of continuous growth and change as the industry continues to grow. Technology development is constantly and rapidly improving the capability to transmit at increasing data rates over even greater distances with fiber-based communication systems.

In the Electro-optics Technology unit, emphasis has been placed on fabrication of precision-wound coils of optical fiber used as the sensing elements of fiber optic gyroscopes. During the past decade, Optelecom has received U.S. Government contracts to investigate advanced manufacturing technology related to gyro coil winding. Optelecom currently pursues this tradition of business development and continues to seek out technology development opportunities with potential for production follow-on. The Electro-optics unit also produces precision wound coils for applications ranging from optical fiber dispensers used in remote vehicle control systems to precision optical fiber coils for communications systems. Additionally, the group is currently engaged in a series of contracts with the U. S. Air Force and prime contractors to develop systems for control of aircraft using optical fiber connections.

The table below displays the Company’s three-year revenue and operating income (loss) by segment:

	2004				2003				2002
Operating Unit	Revenue		Operating Income		Revenue		Operating Income		Revenue		Operating Income
Communication Products	$	17,952,578	$	1,930,646	$	15,327,411	$	1,427,838	$	13,665,771	$	1,235,680
Electro-Optics	1,442,569		339,329		1,792,247		544,497		1,242,783		376,439
Company Totals	$	19,395,147	$	2,269,975	$	17,119,658	$	1,972,335	$	14,908,554	$	1,612,119

RECENT DEVELOPMENT

On March 8, 2005 we acquired NKF Electronics B.V. (NKF), a wholly owned subsidiary of Draka Holding N.V., pursuant to a definitive agreement entered into with Draka Holding N.V. We believe that this transaction establishes Optelecom as a leading global independent producer of comprehensive fiber optic-based communications solutions for video surveillance, traffic monitoring, and business video systems.

NKF Electronics was founded in 1981 and has accumulated extensive expertise in fiber optic and IP/Ethernet network technologies. This expertise has enabled NKF Electronics to build a broad range of

communications products, ranging from fiber optic video modems and multiplexers to complete Video-Over-IP network solutions. All its products are designed and tested for Local, Metropolitan and Wide Area Network (LAN, MAN and WAN) applications, especially those characterized by harsh environmental conditions and by large distances between the individual transmission locations.

The purchase price for the acquisition, subject to final purchase price adjustment, is between 17 and 20 million Euro’s which consisted of a cash payment of 11 million Euro’s ($14.5 million USD) and a 6% subordinated note issued by Optelecom to Draka Holding N.V. for the remainder, which will mature in 2010. The cash portion of the purchase price was funded by a $14.5 million senior term facility provided by M&T Bank, which consists of a Euro based term loan and a US dollar based term loan. The purchase price is subject to post-closing adjustments for working capital and fixed assets. The Optelecom-NKF combination creates a company employing over 150 people worldwide with increased financial resources to support global government and commercial end-users.

The effect of our acquisition of NKF Electronics is not reflected in our year end financial results included in this Form 10-K since the transaction took place subsequent to our year end. The results of NKF’s operations will be included from the date of acquisition to March 31, 2005 in our first quarter 10-Q we plan to file in May 2005. Optelecom filed a Form 8-K describing the transaction and containing copies of the Purchase Agreement, the Subordinated Note and the Loan Agreement, which are hereby incorporated by reference to Exhibit 99.1, Exhibit 99.2, and Exhibit 99.3, respectively to our Form 8-K filed with the Securities and Exchange Commission dated March 11, 2005.

You can learn more about Optelecom at www.optelecom.com and about NKF Electronics at www.nkfelectronics.com

PRODUCTS AND MARKETS

COMMUNICATION PRODUCTS DIVISION (CPD)

The Communication Products Division addresses business opportunities in the worldwide optical communication equipment marketplace, specializing in optical fiber transmission technologies. The majority of CPD’s revenues are and will continue to be derived from several niche markets that apply the advantages of fiber optic telecommunications to their transmission requirements. Presently, the vertical markets we serve include communications systems for highway traffic monitoring, advanced air traffic control video monitor displays, security surveillance and control systems, and manufacturing process and control communications. Vertical markets that offer future potential sources of revenue include video teleconferencing, healthcare, and broadcasting. CPD offers many product solutions to address our customers’ needs. Its products are classified into the following categories:

Data Communications Products

Data Communications Products include a comprehensive family of fiber optic modems that incorporate standard telecommunications protocols. The market applications for these products include specialty data and timing distribution modems for the military, aerospace and satellite earth station markets as well as commercial, industrial, traffic control and surveillance markets.

Uncompressed Digital Video Transmission Products

Uncompressed digital video products provide an extremely high quality video signal over long distances via optical fiber. The bandwidth required to achieve this performance is considerably greater than that needed for lower video quality systems, however, the enormous bandwidth capacity of fiber optic transmission media provides an obvious path for utilization of digital video technology. Additionally, since the video transmission format is strictly digital, it can be easily combined with digitized voice and digital data streams. This feature facilitates switching and multiplexing of a wide variety of signals.

Current products include one, two, four, and eight channel digital video multiplexing and de-multiplexing units offering near-broadcast quality performance, with many also combining audio and data with the digital video for transmission via one optical fiber using one optical wavelength for each transmission direction.

The totally modular approach used in the digital system design architecture reduces the inventory and logistical support investment required to address the increasing demand for these products. Marketplace reception has been positive and new applications involving a combination of our other product offerings with the capabilities of the digital video equipment are being constantly proposed.

CWDM (Course Wavelength Division Multiplexer) Systems

CWDM allows the transmission and reception of multiple channels of light operating at different wavelengths through a single optical fiber. With this technology, the user can configure systems that transport the video and data channel count transmitted by one wavelength (typically up to eight) multiplied by the wavelength channel capacity of the CWDM. Optelecom offers CWDM systems with optical wavelength channel counts from two to seventeen, as well as single channel add/drop multiplexers By using a two channel WDM (Wavelength Division Multiplexer) along with two eight channel digital video multiplexers transmitting at different optical wavelengths, sixteen channels of video along with data and audio may be transmitted via one optical fiber in one direction. Similarly, by using a seventeen channel CWDM (Course Wavelength Division Multiplexer) along with up to seventeen eight channel digital video multiplexers each transmitting at different optical wavelengths, one hundred thirty six channels of very high quality digital video, along with audio and data, may be transmitted via one optical fiber in one direction. Alternately, by using the seventeenth wavelength for return path audio and data, one hundred twenty eight video channels can be transmitted in one direction along with bi-directional audio and data.

Combining Optelecom’s wide variety of transmission products with available CWDM components permits the user to configure multiple variations of point-to-point or distributed linear optical networks for the transmission of video, audio, and data. via a single optical fiber.

High Resolution RGB Video Transmission Products

Red Green Blue (RGB) Video Transmission Products include those used to remotely position a high-resolution display, such as a monitor or projector, from its video source. Because of the high bandwidth and fidelity required to transmit these signals, fiber optics is the only available means to transmit them further than approximately 1,000 feet. While VGA video, in the 1280 x 1024 pixel range, may be transmitted via copper using active baluns (such as offered by the Copper Products unit) up to distances approaching 1,000 feet, the bandwidth required to transmit ultra high resolution 2048 x 2048 pixel RGB video limits the maximum transmission distance possible over copper wire to less than 100 feet. Management is not aware of any other fiber optic RGB video transmission system that meets the performance characteristics of the high-resolution RGB products that we offer. Applications for this technology include air traffic control, military control rooms, remote conference rooms, financial trading desks and process control.

Compressed Digital Video Transmission Products

Applying our expertise in video communications, we have developed a low cost, high quality, compressed digital video MPEG II product set that leverages the advantages of new microprocessor technology recently made available to the marketplace. MPEG II has become the defacto compression standard embraced by the consumer and other electronics marketplaces. The products we have developed will replace older compression products since their low cost, high performance characteristics render the previous family obsolete.

These products involve the digitization and compression of National Television System Committee (NTSC) and Phase Alternation by Line (PAL) video signal sources, allowing transmission using T1, E1, or Ethernet, over IP (Internet Protocol). They are being offered to the security and traffic markets as well as to other markets whose users are turning to video communications as a way to increase productivity. The explosive growth of the Internet facilitates the need for low cost, high quality compressed digital video for use over various private and public networks.

ELECTRO OPTICS TECHNOLOGY UNIT (EO)

The Electro Optics Technology Unit focuses on Interferometric Fiber Optic Gyro (IFOG) coils, which are components in rotation-sensing instruments that are beginning to replace mechanical and laser gyros in aircraft, missiles, and other vehicles. Optelecom has used its expertise derived from prior Department of Defense activities to develop winding technology for IFOG coils and to manufacture these coils. In 2003, continued improvements were incorporated to increase production capacity in anticipation of increased requirements for these coils.

Optelecom currently supports Boeing in a program for Wright-Patterson AFB which is devoted to development of military aircraft photonic network systems. Optelecom is in the implementation stage of an effort to demonstrate photonic vehicle control feedback components. Our photonic aerospace vehicle work provides an opportunity for Optelecom to apply its optical development and fabrication expertise to an important military aircraft system application with subsequent potential in commercial markets.

SALES AND MARKETING

COMMUNICATION PRODUCTS DIVISION (CPD)

The Communication Products Division sells its products domestically through direct sales, select commercial integrators and resellers. In addition, several vendors incorporate Optelecom products in their product offerings. This enables Optelecom to penetrate markets we do not address directly.

The Company continues to focus it’s resources on developing additional sales and distribution channels. Specifically, in 2004 we added three representatives and thirty-nine integrators domestically. Internationally, we added one new representative and thirteen new integrators. We expect this number to continue to grow in 2005 as we further expand the market share of our fiber transmission products.

The Company’s primary method of making new customer contacts has been through participation in an expanded trade show schedule in both the Security and Traffic markets. These trade shows have resulted in a significant increase in quotations and order activity. In addition, our web site (www.optelecom.com) has enabled the convenient and rapid dissemination of information required by our distribution channel personnel and other interested parties to gather information necessary to select our equipment.

ELECTRO OPTICS TECHNOLOGY UNIT (EO)

The Electro-optics unit sales are pursued independently of other corporate sales functions. This unit relies on established contacts, response to request for proposals (RFP’s) and participation in technical conferences to market precision wound coils and other contract services.

RESEARCH AND DEVELOPMENT

	2004		2003		2002
Expenditures on Company sponsored research and development activities	$	1,155,000	$	979,000	$	847,000

During 2004, the Company invested in the development of several new products. These products will permit us to increase our penetration of the present vertical markets we serve by permitting our customers to increase information throughput at reduced price points. It is anticipated that the new Digital Video (DV) products, both compressed and uncompressed, will gain significant market share due to their extremely high reliability, increased bandwidth/channel capacities, and robust video compression techniques.

A network software management card incorporating an Ethernet capability was developed and introduced in 2002. This unit allows remote access to, and management of Optelecom equipment from a customers existing network.

MANUFACTURING PROCESSES

QUALITY ASSURANCE

Optelecom has established and maintains a Quality Assurance system fully compliant with the requirements of the 2000 version of ISO-9001 (an internationally recognized quality system standard for companies that design and manufacture products). All operating segments have received certification to the standard. This certification is re-validated every six months and the company successfully passed audits in January and July of 2004. The Corrective Action process and Quality Council meetings continue to be aggressively utilized to drive continuous improvements.

COMMUNICATION PRODUCTS DIVISION

The Communication Products Division performs routine and specialized manufacturing, assembly, and product testing functions in our corporate headquarters. We use equipment to automatically assemble components onto printed circuit boards at high speed, thereby lowering manufacturing costs and reducing the time-to-market for new product designs. We also maintain a quality assurance function and testing area that performs optical and electrical testing and quality control. Raw materials and supplies used in our business include optical materials, plastic products, and various electronic components, most of which are available from numerous sources. Although the number of companies from which we can obtain optical emitters and detectors for use in our circuit assemblies is limited, availability is presently not a limiting factor. During 2004, manufacturing basics continued to be an area of primary focus. This involved correcting, reassessing and improving many of the core manufacturing processes.

ELECTRO OPTICS TECHNOLOGY

The Electro-Optics unit uses custom facilities designed and fabricated by Optelecom for precision wound coil production and contract research and development. Currently, seven coil winding machines are employed in satisfying contract winding production requirements.

COMPETITION

The two business segments of Optelecom compete in separate and distinct markets.

COMMUNICATION PRODUCTS DIVISION

This Unit competes with other companies of roughly equal size that have similar resources. The majority of our competitors are privately held companies. We estimate the total market for Optelecom transmission products to be approximately $200 million in 2004. The size of the traffic and security surveillance markets, which represents the largest segment, is estimated to be approximately $75 million worldwide. The competition in these markets has established mature sales channels that allow for continued market penetration in both domestic and international markets. We anticipate that the expansion of Optelecom’s sales and distribution channels worldwide will be the basis for sustained growth.

The Company expects to increase its share of these expanding markets. In addition, our products contain two technologies that are in limited supply to these markets: the compressed and uncompressed Digital Video products. We considered NKF Electronics to be one of our primary competitors in this marketplace.

ELECTRO OPTICS TECHNOLOGY

Products offered by Electro-optics are sold to both small companies and large defense contractors who tend to dominate the market. These companies have greater marketing, manufacturing, financial, research and personnel resources than Optelecom. Furthermore, as Department of Defense contracting activity has declined, these companies have started to compete in markets that were primarily addressed by companies with resources similar to Optelecom’s. Our approach to this competitive environment is to offer services and second source production capabilities which complement the capabilities and interests of our customers.

SEASONALITY

Optelecom’s products are based on communications equipment technology. As such, seasonality affects our revenues to the extent that normal contracting activities are affected by capital budget seasonality.

PATENTS

Although Optelecom holds certain patents which relate to optical sensor technology and optical fiber networks, our business as a whole is not materially dependent upon ownership of any one patent or group of patents. We do not license any patents from other parties.

BACKLOG

At the end of 2004, the estimated backlog for each business segment was $400,000 in the Communication Products Division and $150,000 in the Electro Optics Products Unit. The Company expects to recognize a majority of the backlog as revenue in the first quarter of 2005.

EMPLOYEES

At December 31, 2004, a total of 78 full-time employees worldwide were employed at Optelecom, including 12 in research, development and engineering, 16 in sales and marketing, 38 in manufacturing and 12 in general management, administration and finance. The number of employees by operating segment is as follows: Communications Products—74; Electro Optics—4. We expect a slight increase in headcount over the next 12 months, primarily in the areas of sales, marketing and manufacturing. Our future success will depend in part on our ability to attract, train, retain and motivate highly qualified employees. There can be no assurance that we will be successful in attracting and retaining such personnel. Our employees are not represented by any collective bargaining organization and we consider our employee relations to be good.

In connection with our acquisition of NKF Electronics in March 2005, our employee base increased to approximately 150. The NKF Electronics employees located in the Netherlands are part of a collective bargaining agreement.

Item 1A. RISK FACTORS

The statements contained in this report on Form 10-K that are not purely historical are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 and Section 21E of the Securities Exchange Act of 1934, including, without limitations, statements regarding Optelecom’s expectations, hopes, beliefs, anticipations, commitments, intentions and strategies regarding the future. Forward-looking statements include, but are not limited to, statements contained in

“Item 1-Business,” and “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding Optelecom’s business and strategies, product markets, sales, marketing, customer support and service, research and development, manufacturing, competition, backlog, employees, financial performance, revenue and expense levels in the future and the sufficiency of our existing assets to fund future operations and capital spending needs. Actual results could differ from those projected in any forward-looking statements for the reasons, among others, detailed under “Risk Factors” in this Report on Form 10-K. The fact that some of the risk factors may be the same or similar to Optelecom’s past filings means only that the risks are present in multiple periods. We believe that many of the risks detailed here are part of doing business in the industry in which we compete and will likely be present in all periods reported. The fact that certain risks are endemic to the industry does not lessen the significance of the risk. The forward-looking statements are made as of the date of this Form 10-K and we assume no obligation to update the forward-looking statements, or to update the reasons why actual results could differ from those projected in the forward-looking statements.

Fluctuations In Financial Performance

Optelecom has experienced and may, in the future, continue to experience fluctuations in our quarterly and annual operating results. Factors that may cause operating results to vary include, but are not limited to, changing technology, new product transitions, delays in new product introductions, competition, shortages of system components, changes in the mix of products and services sold and timing of investments in additional personnel, facilities and research and development. As a result of the impact of these and other factors, past financial performance should not be considered to be a reliable indicator of the future performance in any particular fiscal period. We are somewhat limited in our ability to reduce expenses quickly in response to any revenue shortfalls. Therefore, Optelecom’s business, financial condition, and operating results could be adversely affected if increased revenues are not achieved.

Dependence On Major Customers

For the twelve months ended December 31, 2004 approximately 21% of our revenues were accounted for by sales to five commercial customers. This is similar to the prior year when five customers also represented 21% of our revenues. In the event of a reduction, delay or cancellation of orders from one or more significant customers or if one or more significant customers selects products from one of our competitors for inclusion in future product generations, our business, financial condition and operating results could be materially and adversely affected. There can be no assurance that Optelecom’s current customers will continue to place orders with us, that orders by existing customers will continue at current or historical levels or that we will be able to obtain orders from new customers. The loss of one or more of our current significant customers could materially and adversely affect Optelecom’s business, financial condition and operating results.

Technological Change

Optelecom’s products are sold in markets that are subject to rapid technological change. Our future success will depend in part upon our ability to enhance our current products and to develop and introduce new products that keep pace with technological developments and emerging industry standards and that address the increasingly sophisticated needs of our customers. There can be no assurance that we will be successful in developing and marketing such products or producing enhancements that meet these changing demands, that Optelecom will not experience difficulties that could delay or prevent the successful development, introduction and marketing of these products or that our new products and product enhancements will adequately meet the demands of the marketplace and achieve market acceptance. Our inability to develop and introduce new products or product enhancements in a timely manner or our failure to achieve market acceptance of a new product could have a material adverse effect on Optelecom.

Competition

We face intense and increasing competition from a large number of competitors, some of which are larger than Optelecom and have larger product development, research and sales staffs. We believe that the products developed in 2003 and 2004 and the products currently being developed will position us to compete effectively through 2005 and well into 2006. There can be no assurance, however, that our competitors will not develop products that are as, or possibly more, effective than ours. We continuously monitor our competitors’ product introductions to evaluate our ability to compete.

Acquisitions

Optelecom has recently completed the acquisition of NKF Electronics B.V. which is substantially similar in size to Optelecom. The acquisition of the foreign subsidiary involves increased risks relating to foreign currency risk exposure, increased financing costs as a result of increased borrowings to effectuate the transaction, increasing the debt of the Company and additional responsibilities imposed upon management involving post-acquisition assimilation activities end oversight of operations of the newly acquired subsidiary. All of these risks are magnified by the increase in size of the Company as a result of the acquisition.

While management believes that the transaction will be accretive, if it is not, the Company may be required to pursue equity financing to refinance the acquisition debt and enter into foreign currency hedges to reduce the exchange rate risk. Management believes that the individuals that it retained at NKF Electronics will continue the successful operations in the future and continue the effective management of NKF.

The Company may also, in the future, acquire additional subsidiaries. Any such additional acquisitions would involve similar risks as discussed herein.

Future Capital Needs; Uncertainty Of Additional Funding

Optelecom believes that our existing capital resources, including an existing $5,000,000 bank line-of-credit and future operating cash flows, will generate the funds needed for our long-term cash requirements.

If our growth rate should exceed expectations, or if we should fail to generate the anticipated operating cash flows, Optelecom would be required to seek additional funding. In those circumstances, the Company would look to increase its line of credit and/or pursue equity financing. There can be no assurance that additional financing will be available in a timely manner or on acceptable terms. If issuing equity securities raises additional funds, further dilution to existing stockholders will result. If adequate funds are not available when needed, we may be required to delay, scale back or eliminate product research and development and overhead costs.

Need To Attract And Retain Key Employees

Optelecom is substantially dependent on the business and technical expertise of our senior management and on our ability to attract and retain key management and technical employees. The loss of members of senior management or of other key employees or our inability to attract and retain other employees with necessary business or technical skills in the future would have a material adverse effect on Optelecom’s business.

Price Volatility In Public Market

Optelecom’s Common Stock currently trades on the NASDAQ Small Cap Market. The securities markets have from time-to-time experienced significant price and volume fluctuations that were unrelated to our operating performance. In addition, the market prices of the common stock of many publicly traded

technology companies have in the past been, and can in the future be expected to be, especially volatile. Announcements of technological innovations or new products of Optelecom or our competitors, developments or disputes concerning proprietary rights, publicity regarding products under development by Optelecom or our competitors, regulatory developments in both the United States and foreign countries, and economic and other external factors, as well as period-to-period fluctuations in our operating and product development results, may have a significant impact on the market price of Optelecom’s Common Stock.

Absence Of Dividends; Dilution

Optelecom has not paid any cash dividends since our inception and we do not anticipate paying any cash dividends in the foreseeable future. Dilution will occur upon the exercise of outstanding stock options and may occur upon future equity financing that could be required to fund operations.

Item 2. PROPERTIES

The Company’s corporate office and manufacturing facility are located at 12920 Cloverleaf Center Drive, Germantown, Maryland. This facility has 30,000 square feet of space, 26,000 of which are occupied by Optelecom, with the remaining 4,000 square feet sub-leased. Our facility has been specifically designed and fitted to accommodate our current requirements and our anticipated near-term growth needs.

Optelecom Europe Limited has its facilities in Thatcham, England, consisting of approximately 2,100 square feet of office space. This lease expires in June 2006, and the premises are in good repair, and are adequate for current requirements.

NKF Electronics maintains its corporate office and manufacturing facility in Gouda, the Netherlands, and has sales offices in Spain, France and Singapore.

Management believes that the Company’s current facilities are sufficient to meets its current and foreseeable needs.

Item 3. LEGAL PROCEEDINGS

From time to time, Optelecom is involved in legal proceedings and litigation arising in the ordinary course of business. As of the date of this report Optelecom is not a party to any litigation or other legal proceeding that, in the opinion of management, could have a material adverse effect on our business, financial condition or results of operations.

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matter was submitted for a vote of our shareholders during the fourth quarter of 2004.

PART II

Item 5. MARKET FOR REGISTRANT’S COMMON STOCK AND RELATED STOCKHOLDER MATTERS

The Company’s Common Stock, representing its only class of publicly traded equity securities, is traded on the NASDAQ Small-Cap market under the symbol OPTC. Set forth below are the highest and lowest closing bid prices for the Common Stock as reported by the National Association of Securities Dealers Automated Quotation Service (NASDAQ) during each quarter for the two years ended December 31, 2004 and 2003, respectively. Such quotations do not necessarily reflect actual transactions:

	Bid Price
	High		Low
Quarter Ended
December 31, 2004	$	9.50	$	8.48
September 30, 2004	10.79		7.90
June 30, 2004	14.44		9.42
March 31, 2004	12.65		8.91
December 31, 2003	13.88		8.65
September 30, 2003	15.99		10.24
June 30, 2003	12.95		7.71
March 31, 2003	8.67		4.23

There were 575 record holders of the Common Stock as of December 31, 2004. The Company has never declared or paid any cash dividends on its common stock and does not expect to do so in the foreseeable future. The Company intends to retain any future earnings to finance its operations and fund the growth of the business. Any payment of future dividends will be at the discretion of the Board of Directors of the Company and will depend upon, among other things, the Company’s earnings, financial condition, capital requirements, and other factors that the Company’s Board of Directors deems relevant.

Listed below is information on the Company’s equity compensation plans as of March 18, 2005.

Plan Category	Number of securities to be issued upon exercise of outstanding options (a)		Weighted average Exercise price of outstanding options (b)			Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in Column (a) (c)
Equity compensation plans approved by security holders		361,984		$	7.23		315,808
Equity compensation plans not approved by security holders		—		—			—
Totals		361,984		$	7.23		315,808

Item 6. SELECTED CONSOLIDATED FINANCIAL DATA

The following table sets forth selected historic consolidated financial data for the periods and dates indicated that has been derived from the Company’s audited consolidated financial statements which have been audited by the Company’s independent registered public accounting firm. The information set forth below is qualified in its entirety by, and should be read in conjunction with, the consolidated financial statements, the related notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations.

	2004		2003		2002		2001			2000
Year ended December 31,
Revenues, net	$	19,395,147	$	17,119,658	$	14,908,554	$	13,176,919		$	10,676,829
Net income (loss)	1,594,612		3,553,266		1,644,120		(933,585		)	(5,998,852		)
Basic earnings (loss) per common share	0.50		1.18		0.58		(0.33		)	(2.53		)
Diluted earnings (loss) per common share	0.49		1.11		0.56		(0.33		)	(2.53		)
As of December 31,
Total assets	12,366,409		10,431,897		6,627,223		6,373,679			6,872,492
Long-term obligations	242,944		164,020		—		69,111			663,642
Stockholders’ equity	9,934,283		7,956,476		3,667,833		2,086,557			2,958,998

Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

ACQUISITION OF NKF ELECTRONICS

On March 8, 2005, the Company completed the acquisition of NKF Electronics pursuant to the terms and conditions of the Share Purchase Agreement. The purchase of NKF should effectively double the size of the Company’s operations and revenue, firmly establishing the Company’s position as the leading world-wide independent producer of fiber optic-based communications solutions for video surveillance, traffic monitoring, and business video systems. The integration of the companies will result in expanded and diversified revenue streams, enhanced research and development capabilities, and a more extensive sales and service organization, addressing the world-wide marketplace for the products of both companies.

Through the acquisition of NKF, we join two strong product lines and two sales units with little geographic overlap, and bring to market industry-leading, advanced communication solutions for mission critical video surveillance, intelligent transportation, and business video systems. We believe that by combining our research and development services and other resources, we can deliver excellent quality products to our customers at great values.

NKF’s primary market position and focus is centered in Europe, while Optelecom is an industry leader in the U.S. marketplace. The Optelecom/NKF combination will create a diversified company that is a global leader in the video surveillance and intelligent transportation markets. The Optelecom-NKF combination creates a company employing over 150 people worldwide with increased financial resources to support global government and commercial end-users.

The following table presents the summary financial results of NKF Electronics for the years ended December 31, 2004 and 2003.

	2004			2003
	(amounts in $000’s)*
Revenue	$	19,008		$	15,501
Cost of goods sold	7,574			6,187
Gross profit	11,434			9,314
Sales, general and administrative	6,676			4,772
Income from operations	4,758			4,542
Other revenue and expenses	(152		)	(85		)
Income taxes	1,591			1,570
Net income	$	3,015		$	2,887

* amounts in USD 000’s, based on average annual exchange rates

The purchase price for the acquisition, subject to final purchase price adjustment is between 17 and 20 million Euro’s, which consisted of a cash payment of 11 million Euro ($14.5 million USD) and a 6% subordinated note issued by Optelecom to Draka Holding N.V. for the remainder. The cash portion of the purchase price was funded by a $14.5 million senior term facility provided by M&T Bank, which consists of a Euro based term loan and a US dollar based term loan. The Subordinated Note accrues interest at a rate of 6% per annum and is due and payable in full on March 8, 2010. The Acquisition Consideration is subject to post-closing adjustment in accordance with the terms and conditions of the Purchase Agreement. The amount of consideration was determined on the basis of arm’s length negotiations between the Company and Draka.

The Company also replaced its current line of credit with a revolving credit facility in an amount not to exceed $5,000,000 to be made available to the Company and NKF for the purpose of obtaining letters of credit and financing the Company’s and NKF’s working capital needs.

RESULTS OF OPERATIONS

Optelecom designs, develops, manufactures and markets high-bandwidth fiber optic-based communications systems for traffic monitoring, security / surveillance, and business video systems. Over the past two years the Company has aggressively pursued several operational objectives including: 1) the expansion of a distribution network both in the United States and abroad, 2) realization of manufacturing and process improvements, 3) implementation of a cost and asset management program and 4) the comprehensive upgrade of our computer networks, operating systems and core financial, sales and manufacturing software platforms.

The successful execution of these initiatives along with increased demand in our core markets has enabled the Company to significantly improve its financial condition in 2003 and 2004, as evidenced by increasing levels of profitability and positive cash flow. The Company will continue in 2005 to work at broadening its sales channels, sustaining gross profit margins and controlling costs.

2004 versus 2003

2004 consolidated revenues of $19.4 million were $2.3 million or 13% higher than 2003. Sales increased in the Communication Products Division and decreased slightly in the Electro-Optics Unit. Revenue for the Communication Products Division increased by $2.6 million or 17%. This increase is attributed to the Company’s continued focus of increasing sales channels both domestically and internationally. Sales to integrators and end users increased substantially over the prior year. While product pricing remained relatively stable between 2003 and 2004, the sales growth was attributable to increased sales orders and increased units sold. Electro-Optics revenues decreased to $1.4 million in 2004 from $1.8 million in 2003 as a result of less activity in the contract services sector.

Gross profit was $11.1 million in 2004 compared to $9.3 million in 2003. This 20% increase of $1.8 million is primarily the result of a higher volume of sales of 9-bit and 10-bit digital products in 2004, which had higher profit margins in 2004 compared to 2003 as a result of continued improvements in manufacturing efficiencies and reductions in material costs over the prior year. As a percentage of sales, our gross margin increased by 3% from 54% in 2003 to 57% in 2004. The Company expects margins in 2005 to be comparable to 2004.

Operating expenses were $8.9 million in 2004 compared to $7.3 million in 2003. This increase of $1.6 million or 21% is primarily due to increases in spending for administrative, sales and engineering personnel, sales advertising and trade show costs and higher occupancy costs. As a percentage of revenue our operating expenses increased 3% from 43% in 2003 to 46% in 2004. In 2002 our operating expense as a percent of revenue was 44%.

The Company reported net income in 2004 of $1.6 million or $0.49 per diluted share compared to net income of $3.6 million or $1.11 per diluted share in 2003. The Company’s 2003 net income included a $1.6 million tax benefit due to the reversal of the deferred tax valuation allowance. The Company based its 2003 decision to reverse the deferred tax valuation allowance on its consistently strong profit performance. The Company began to recognize tax expense in 2004.

2003 versus 2002

2003 consolidated revenues of $17.1 million were $2.2 million or 15% higher than 2002. Sales increased in both the Communication Products Division and Electro-Optics Unit. Revenue for the

Communication Products Division increased by $1.7 million or 12%. This increase is attributed to the Company’s continued focus of increasing sales channels both domestically and internationally. Sales to integrators, distributors and end users increased substantially over the prior year. While product pricing remained relatively stable between 2002 and 2003, the sales growth was attributable to increased sales orders and increased units sold. Electro-Optics revenues increased to $1.8 million in 2003 from $1.2 million in 2002 as a result of expansion of the contract services and the coil winding businesses.

Gross profit was $9.3 million in 2003 compared to $8.1 million in 2002. This 15% increase of $1.2 million is primarily the result of a higher volume of sales of digital and data communications products in 2003, which had higher profit margins in 2003 compared to 2002 as a result of continued improvements in manufacturing efficiencies and reductions in material costs over the prior year. As a percentage of sales, our 2003 gross margin remained constant with our 2002 gross margin at 54%.

Operating expenses were $7.3 million in 2003 compared to $6.5 million in 2002. This increase of $0.8 million or 13% is primarily due to increases in spending for engineering personnel, sales advertising and trade show costs and higher occupancy costs as a result of the Company’s move to a larger and expanded facility early in 2003. As a percentage of revenue our operating expenses declined 1% from 44% in 2002 to 43% in 2003. As our revenue increases we are experiencing a reduction in our operating expenses as a percentage of revenue. In 2001 our operating expense as a percent of revenue was 53%.

The Company reported net income in 2003 of $3.6 million or $1.11 per diluted share compared to net income of $1.6 million or $0.56 per diluted share in 2002. The Company’s 2003 net income includes a $1.6 million tax benefit due to the reversal of the deferred tax valuation allowance. The Company based its decision to reverse the deferred tax valuation allowance on the consistently strong profit performance over the last two and one-half years, along with our expectation of continued future profitability.

Operating Segments

Optelecom’s products and services are categorized into two operating segments: the Communication Products Division and the Electro-Optics Technology Division. During 2003 management decided to combine the Copper Products unit and the Optical Products unit into the Communication Products Division in order to manage the business more effectively. The financial results for the two operating segments have been prepared on a basis that is consistent with the manner in which Optelecom management internally evaluates financial information for the purpose of assisting in making internal operating decisions. In this regard, certain common expenses have been allocated among segments differently than would be required for stand alone financial information prepared in accordance with accounting principles generally accepted in the United States of America.

COMMUNICATION PRODUCTS DIVISION

Communication Products Division	2004		2003		2002
Net Sales	$	17,952,579	$	15,327,411	$	13,665,771
Gross Profit	10,553,077		8,438,028		7,500,348
Total Operating Expense	8,622,432		7,023,204		6,264,668
Operating Income (Loss)	1,930,645		1,427,838		1,235,680

2004 sales for the Communication Products Division of $18.0 million were 18% or $2.6 million higher than 2003’s sales of $15.3 million. This increase is attributed to the Company’s focus of increasing sales channels both domestically and internationally. Sales to integrators and end users increased substantially over the prior year.

In 2004 the Communication Products Division continued to experience the benefits of the expansion and re-alignment of its sales and marketing departments. The emphasis that was placed on developing new sales and distribution channels, both domestically and internationally resulted in higher sales in 2004. During 2004, three independent sales representative organizations and thirty-nine integrators were added domestically and one independent sales representative organization and thirteen integrators were added in the international marketplace. The Company expects to continue to add independent sales representative organizations and integrators both domestically and internationally in 2005.

Gross profit during 2004 of $10.6 million, or 59% of sales, was higher than 2003’s gross profit of $8.4 million or 55% of sales. The increase of $2.2 million is primarily the result of the higher volume of sales of digital and data communications products in 2004. The lower gross profit margin in 2003 is mainly attributable to significantly lower margins on a large installation for the Olympic Games in Athens, Greece. Management determined that the benefit of having our technology showcased at this premier venue provided exposure to a level of potential customers that could not be easily reached otherwise. The Company expects margins in 2005 to be comparable to 2004.

Operating expenses were $8.5 million in 2004 compared to $7.0 million in 2003. Sales and marketing costs increased $0.7 million over 2003, primarily due to higher employee costs, advertising and trade show costs. Engineering costs increased $0.2 million, primarily due to higher staff costs in 2004. General and administrative costs increased $0.6 million from $3.1 million in 2003 to $3.7 million in 2004. Cost increases are primarily attributed to the increases in personnel and occupancy costs.

ELECTRO-OPTICS TECHNOLOGY UNIT

	2004		2003		2002
Net Sales	$	1,442,568	$	1,792,247	$	1,242,783
Gross Profit	575,247		845,253		598,189
Total Operating Expense	235,917		300,756		221,750
Operating Income	339,330		544,497		376,439

Electro-Optics sales of $1.4 million in 2004 were $0.4 million lower than 2003. The decrease is primarily attributable to the lower sales under the contract research and development portion of the business in 2004 when compared to 2003. There was a slight increase in the unit sales of the coil winding division from 2003 to 2004. Operating income for 2004 decreased also as a result of lower contract research and development sales.

OTHER INCOME (EXPENSE)

	2004			2003			2002
Interest expense—line of credit	$	—		$	(11,483	)	$	(77,442	)
Interest expense—long term notes / other	(5,445		)	(3,465		)	(13,422		)
Interest / other income	25,760			4,602			139,540
Total other income (expense)	$	20,315		$	(10,346	)	$	48,676

Other income (expenses) totaled $20,315 in 2004 compared to ($10,346) in 2003. Total interest income was $25,760 in 2004 compared to $4,602 in 2003. Interest income for 2004 increased as result of higher cash balances. Other income in 2002 represents a refund of federal income taxes paid in a prior year.

Impact of Inflation

Inflation has not had a significant effect on the operations of the Company during 2004, and we do not expect it to have a significant effect during 2005.

FINANCIAL CONDITION

The Company’s Stockholders’ equity increased from $8.0 million in 2003 to $9.9 million in 2004. The net income of $1.6 million was accompanied by an increase of $0.3 million in common stock and paid-in-capital, due to the exercise of stock options and purchase of shares pursuant to the employee stock purchase plan.

Other key components of Optelecom’s financial condition include accounts receivable, inventory, fixed assets and accounts payable. The Company’s current ratio has increased to 4.61 at December 31, 2004 compared to 3.59 at December 31, 2003. This increase is attributed primarily to the increase in cash from $1.4 million to $2.9 million and the $0.3 million decrease in the Company’s balance in accounts payable. Accounts receivable increased this year from $2.8 million in 2003 to $3.0 million at December 31, 2004. A significant factor in this increase was relatively large shipments late in 2004 compared to 2003.

Inventory increased slightly from $2.7 million at December 31, 2003 to $2.9 million at December 31, 2004 primarily due to increases in production materials and finished goods inventories. These increases were due to the Company’s decision to increase stocking levels to meet customer requirements, primarily for the growing security and surveillance market. As a result of the lessening of exposure to component shortages, the Company has been able to focus on stocking material at subassembly and finished good levels. This results in our ability to service our customer’s requirements in less time while benefiting from lower investment in overall inventories.

The following chart shows the composition of inventory for the past three years, with Optelecom Europe Limited’s inventory included in finished goods:

	2004			2003			2002
Production Materials	$	1,604,605		$	1,637,331		$	1,367,886
Work in Process	192,145			414,639			210,637
Finished Goods	1,164,264			889,022			1,178,674
Allowance for Obsolescence	(93,132		)	(279,992		)	(303,996		)
TOTAL	$	2,867,882		$	2,661,000		$	2,453,201

In 2004, fixed asset additions were $0.9 million, compared to $1.0 million in 2003 and $0.12 million in 2002. During 2002 the Company had adopted a conservative policy on capital purchases in its effort to curtail spending and improve profitability. During 2003 and 2004, as the Company’s profitability continued to improve, capital spending was increased in order to improve and expand on engineering and factory capabilities. While the Company does not currently have any capital asset purchase commitments, we anticipate an investment in capital expenditures of approximately $1.0 million in 2005.

The Company’s current liabilities decreased $0.1 million from $2.3 million in 2003 to $2.2 million in 2004 primarily as a result of a decrease of $0.3 million in accounts payable which was offset by slight increases in accrued payroll and warranty reserve totaling $0.15 million. During 2003 the Company incurred short term note indebtedness of $0.07 million as a result of purchasing new capital equipment under a financing arrangement.

Likewise, long-term debt was increased in 2003 by $0.09 million as a result of purchasing new capital equipment under a financing arrangement. In addition, the Company incurred a deferred rent liability in

2003 as a result of entering into a new lease term on the Company’s U.S. office space. This deferred rent liability increased from $0.06 million in 2003 to $0.19 million in 2004.

LIQUIDITY AND CAPITAL RESOURCES

The Company’s operating activities have provided positive cash flows for 2004 and 2003. Cash provided by operating activities was $2.1 million in 2004 compared to $2.3 million in 2003.

Cash used in investing activities in 2004 decreased slightly to $0.9 million compared to $1.0 million in 2003. The Company continued to be active in capital asset acquisition during 2004 in an effort to improve and expand the manufacturing capabilities and the computer network infrastructure.

During 2004, financing activities provided $0.4 million compared to $0.09 million provided by financing activities during 2003. Cash provided by financing activities resulted from the reclassification of a $0.14 million restricted certificate of deposit from non-current to current assets. Additionally, proceeds from the exercise of stock options and common stock issued from the employee stock purchase plan totaled $0.35 million during 2004.

Under its current banking facility, the Company has the ability to borrow up to $3.5 million under its existing bank line-of-credit as of December 31, 2004, provided there are sufficient accounts receivable and inventory. This facility consists of two components: (a) a demand working capital line of credit which will enable the Company to borrow up to the lesser of $3.0 million or the borrowing base; and (b) a $500,000 transaction specific revolving demand export line of credit for short-term financing. The amount available will be the lesser of $500,000 or the borrowing base. The Company’s borrowing base under the first facility equals the sum of 90% of eligible government billed accounts receivable, 80% of the eligible commercial billed accounts receivable and 20% of eligible related inventory capped at $500,000. The Company’s borrowing base under the second facility equals the sum of 80% of the eligible export-related inventory and 90% of the eligible export-related accounts receivable. This facility is guaranteed 90% by the Export-Import Bank of the United States (“Ex-Im Bank”) under Ex-Im Bank’s Working Capital Guarantee Program.

The first facility carries interest at the rate of LIBOR (3.10% at December 31, 2004) plus 3.5%. The second facility carries interest at the rate of PRIME (5.25% at December 31, 2004) plus 1.25%, floating.

Optelecom is required to comply with certain financial ratios including maintaining a minimum current ratio, a maximum debt to worth ratio, a maximum funded debt to EBITDA ratio and a minimum tangible net worth ratio. The Company was in compliance with all of these covenants at December 31, 2004.

Optelecom’s future working capital needs will be financed by our operating cash flow and continued use of the line-of-credit. In the event that operating cash flows become insufficient to meet funding needs, the Company may be required to scale back or eliminate product research and development and overhead costs. Additionally, the Company would look to increase its line of credit and/or pursue equity financing. The Company’s strategy will focus on identifying new products that meet the demands of our core markets, expanding our distribution channels and implementing processes which will increase manufacturing efficiencies. Management fully understands the costs required to execute this strategy and will pursue these initiatives in a timely and fiscally prudent manner.

The following are our contractual obligations as of December 31, 2004 are as follows:

	Total		Less Than 1 Year		1–3 Years		4-5 Years		More Than 5 Years
Long-term debt obligations	$	90,000	$	45,000	$	45,000	$	—	$	—
Capitalized lease obligations	—		—		—		—		—
Operating lease obligations(1)	4,738,428		519,031		1,548,746		1,098,999		1,571,652
Purchase obligations	—		—		—		—		—
Totals	$	4,811,644	$	564,031	$	1,593,746	$	1,098,999	$	1,571,652

(1) Operating leases include our office space in the U.S. and the U.K. Total rental expense under these leases for fiscal year 2004 was $565,731.

As described above, in connection with the acquisition of NKF Electronics the Company entered in new acquisition related debt agreements.

NEW ACCOUNTING STANDARDS

In November of 2004, FASB issued Statement No 151, Inventory Costs, an amendment of Accounting Research Bulletin No. 43, Chapter 4 (SFAS 151). The amendments made by SFAS 151 clarify that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current period charges and require the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. The FASB’s goal is to promote convergence of accounting standards internationally by adopting language similar to that used in the International Accounting Standard 2, Inventories adopted by the International Accounting Standards Board (IASB). The Boards noted that the wording of the original standards were similar but were concerned that the differences would lead to inconsistent application of those similar requirements. The guidance is effective for inventory costs incurred during the Company’s year beginning January 1, 2006. The Company does not believe that the adoption of the new standard will have a material impact on its financial position.

The FASB issued FSP No. 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004 (FSP 109-2) to provide guidance under SFAS 109 regarding the American Jobs Creation Act of 2004 (the “Jobs Act”) enacted on October 22, 2004. The Jobs Act provides for a special one-time dividends received deduction on the repatriation of certain foreign earnings to a US taxpayer. FSP 109-2 contains provisions allowing companies to apply the provisions of FAS 109 after the period in which the Jobs Act was enacted. The Company is evaluating the effect of the Jobs Act on its plan for reinvestment or repatriation of foreign earnings. The Company has not completed its evaluation and has not adjusted its tax calculations to reflect the repatriation provisions of the Jobs Act as allowed by FSP 109-2.

On December 16, 2004, the FASB issued Statement No. 123 (revised 2004), Share-Based Payment (SFAS 123R), which is a revision of SFAS 123. SFAS 123R supersedes APB 25 and amends FASB Statement No. 95, Statement of Cash Flows. Generally, the approach in SFAS 123R is similar to the approach described in SFAS 123. However, SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. SFAS 123R must be adopted no later than July 1, 2005. Early adoption will be permitted in periods in which financial statements have not yet been issued. The Company expects to adopt SFAS 123R on July 1, 2005.

(a) based on the requirements of SFAS 123R all share-based payments granted after the effective date and (b) based on the requirements of SFAS 123 for all awards granted to employees prior to the effective date of SFAS 123R that remain unvested on the effective date or (ii) a “modified retrospective” method which includes the requirements of the modified prospective method described above, but also permits entities to restate based on the amounts previously recognized under SFAS 123 for purposes of pro forma disclosures either (a) all prior periods presented or (b) prior interim periods of the year of adoption. The Company is currently evaluating the method it will use when it adopts SFAS 123 R

Both SFAS 123 and SFAS 123R require measurement of fair value using an option-pricing model. Although the Company currently uses the Black-Scholes model, the Company may determine that a lattice model provides a better estimate of fair value for its employee stock options. The Company has not determined which model it will use for new awards issued and for awards modified, repurchased or cancelled on or after the effective date, July 1, 2005. All awards granted prior to July 1, 2005 will maintain their grant-date value as calculated under SFAS 123. The future compensation cost for the portion of these awards that are unvested (the service period continues after date of adoption) will be based on their grant-date value adjusted for estimated forfeitures. The Company currently adjusts the pro forma expense for forfeitures only as they occur.

As permitted by SFAS 123, the Company currently accounts for share-based payment to employees using APB 25’s intrinsic value method and consequently recognizes no compensation cost for employee stock options. Accordingly, the adoption of SFAS 123R’s fair value method will have an impact on the result of operations, although it will have no impact on the Company’s overall financial position. The impact of adoption of SFAS 123R cannot be predicted because it will depend on levels of share-based payments granted in the future. However, had adoption of SFAS 123R occurred in prior periods, the impact of that standard would have approximated the impact of SFAS 123 as described in the disclosure of pro forma net income and earnings per share in Note 1 of the consolidated financial statements.

CRITICAL ACCOUNTING POLICIES

Optelecom’s discussion and analysis of its financial condition and results of operations are based upon Optelecom’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires Optelecom to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, Optelecom evaluates its estimates, including those related to product returns, bad debts, inventories, income taxes, financing operations, warranty obligations, and contingencies and litigation. Optelecom bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We consider certain accounting policies related to revenue recognition, valuation of accounts receivable, inventory, stock-based compensation and income taxes to be critical to our business operations and the understanding of our results of operations. The impact and any associated risks related to these policies on our business operations is discussed throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations where such policies affect our reported and expected financial results. For a detailed discussion on the application of these and other accounting policies, see Notes to the Consolidated Financial Statements in Item 14 of this Annual Report on Form 10-K.

Revenue Recognition—Revenue from commercial sales is recognized when product is shipped and accepted. Revenues from fixed-price contracts, such as contracts from the government, are recognized on the percentage-of-completion method, which relies on estimates of total expected contract revenue and

costs. Optelecom follows this method since reasonably dependable estimates of the revenue and costs applicable to various stages of a contract can be made. Recognized revenues and profit are subject to revisions as the contract progresses to completion. Revenues from time-and-materials contracts are recorded at the contract rates times the labor hours plus other direct costs as incurred. In the ordinary course of business, the Company warrants its products against defect in design, materials, and workmanship over various time periods. Warranty reserve and allowance for product returns is established based upon management’s best estimates of amounts necessary to settle future and existing claims on products sold as of the balance sheet date. Beginning December 2002, the Company established a warranty reserve for expenses associated with future warranty claims. This reserve is updated on a quarterly basis.

Allowance for Doubtful Accounts—Optelecom maintains allowances for doubtful accounts for estimated losses resulting from the inability of customers to make required payments. The Company regularly monitors and assesses its risk of not collecting amounts owed to it by its customers. This evaluation is based upon an analysis of amounts currently and past due along with relevant history and facts particular to the customer such as collection history and the results of credit inquiries. If the financial condition of Optelecom’s customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

Inventories—Production materials are valued at the lower of cost or market applied on a standard cost basis. Work-in-process represents direct labor, materials, and overhead incurred on products not delivered to date. Finished goods inventories are valued at the lower of cost or market, cost being determined using standards that approximate actual costs on a specific identification basis. Optelecom writes down its inventory for estimated obsolescence or unmarketable inventory based upon assumptions about future demand and market conditions as well as historical inventory turnover. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required.

Income Taxes—The company accounts for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes” which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the book and tax bases of recorded assets and liabilities. SFAS No. 109 also requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred tax asset will not be realized.

At December 31, 2004 and 2003, the company had deferred tax assets in excess of deferred tax liabilities of $1.2 million and $1.7 million, respectively. For the reasons cited below, at December 31, 2004 and 2003, management determined that it is more likely than not that $1.2 million and $1.7 million, respectively, of such assets will be realized, resulting in a valuation allowance of $0.0 million and $0.0 million, respectively.

The company evaluates quarterly the realizability of its deferred tax assets by assessing its valuation allowance and by adjusting the amount of such allowance, if necessary. The factors used to assess the likelihood of realization are the company’s forecast of future taxable income and available tax planning strategies that could be implemented to realize the net deferred tax assets. The company has used tax planning strategies to realize or renew net deferred tax assets in order to avoid the potential loss of future tax benefits.

Approximately $3.4 million of future taxable income (predominately U.S.) ultimately is needed to realize the net deferred tax assets at December 31, 2004. Failure to achieve forecasted taxable income might affect the ultimate realization of the net deferred tax assets. Factors that may affect the company’s ability to achieve sufficient forecasted taxable income include, but are not limited to, the following: increased competition, a decline in sales or margins, loss of market share, delays in product availability or technological obsolescence.

In addition, the company operates within multiple taxing jurisdictions and is subject to audit in these jurisdictions. These audits can involve complex issues, which may require an extended period of time to resolve. In management’s opinion, adequate provisions for income taxes have been made for all years.

Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISKS

Market risk is the potential change in an instrument’s value caused by, for example, fluctuations in interest and currency exchange rates. The Company has not purchased any futures contracts nor purchased or held any derivative financial instruments for trading purposes during the twelve months ended December 31, 2004 and 2003. The primary market risk exposure is the risk that interest rates on our outstanding borrowings may increase. Optelecom also faces market risk exposure as a result of foreign currency translation adjustments of the Company’s foreign subsidiaries, Optelecom Europe Limited and NKF Electronics B.V.. The Company believes this risk is immaterial.

Optelecom currently has no borrowings under its bank line-of-credit. Optelecom has not entered into any hedging arrangements with respect to any prior interest obligations under these lines of credit.

CERTAIN RISKS OF FOREIGN OPERATIONS

The Company has two wholly-owned subsidiaries, Optelecom Europe Limited and NKF Electronics B.V., which operate primarily in countries outside the United States and are subject to certain risks such as currency exchange rates. There can be no assurances that these factors will not have an adverse impact on our future international sales or operating results. We do not currently enter into foreign currency hedging transactions and therefore may be exposed to possible losses on international transactions.

OPTELECOM, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31,

	2004			2003			2002
Cash Flows From Operating Activities
Net income	$	1,594,612		$	3,553,266		$	1,644,120
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
Depreciation and amortization	430,180			332,822			360,927
Loss on disposal of equipment	—			—			8,110
Write off discount on common stock	—			—			11,161
Accounts receivable provision	41,111			(54,356		)	54,697
Inventory provision	(186,859		)	(24,005		)	(48,704		)
Stock based compensation	24,900			—			6,432
Deferred rent	123,924			62,494			(33,111		)
Deferred tax asset	553,816			(1,624,158		)	—
Change in assets and liabilities:
Accounts and contracts receivable	(221,742		)	384,120			(741,373		)
Inventories	(20,023		)	(183,794		)	391,151
Prepaid expenses and other assets	(179,416		)	(157,178		)	(45,502		)
Other assets	—			126,062			(126,062		)
Accounts payable	(253,445		)	80,994			(275,667		)
Other current liabilities	153,726			(219,399		)	624,609
Net cash provided by operating activities	2,060,784			2,276,868			1,830,788
Cash Flows From Investing Activities
Proceeds from sale of equipment	—			—			5,841
Security deposit	—			11,526			—
Capital expenditures	(948,363		)	(980,205		)	(123,510		)
Net cash used in investing activities	(948,363		)	(968,679		)	(117,669		)
Cash Flows From Financing Activities
Borrowings on bank line-of-credit payable	—			2,020,551			11,406,756
Payments on bank line-of-credit payable	—			(2,596,630		)	(12,506,542		)
Payments on notes payable and capital leases	(67,500		)	(23,506		)	(543,777		)
Decrease in restricted certificate of deposit	129,368			—			—
Proceeds from issuance of common stock	59,569			58,636			64,226
Proceeds from exercise of stock options	294,220			633,847			40,928
Net cash provided by (used in) financing activities	415,657			92,898			(1,538,409		)
Effect of exchange rates on cash and cash equivalents	3,015			(61,210		)	(185,591		)
Net increase (decrease) in cash and cash equivalents	1,531,093			1,339,878			(10,881		)
Cash and cash equivalents—beginning of period	1,387,866			47,988			58,869
Cash and cash equivalents—end of period	$	2,918,959		$	1,387,866		$	47,988
Supplemental Disclosures of Cash Flow Information:
Cash paid during the year for interest	$	5,445		$	15,436		$	105,895
Cash paid during the year for income taxes	$	57,564		$	36,374		$	—
Supplemental information on non-cash investing and financing activities:
Notes and capital lease obligations incurred for new equipment	$	—		$	180,000		$	4,800

The accompanying notes are an integral part of these consolidated financial statements.

OPTELECOM, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000

	Number of Shares	Common Stock			Discount on Common Stock			Additional Paid-in Capital		Deferred Compensation				Accumulated Deficit				Accumulated Other Comprehensive Income				Treasury Stock			Total Stockholders’ Equity
BALANCE, JANUARY 1, 2002	2,833,321		85,000		(11,161		)	10,048,911			(6,432		)		(6,991,843		)		227,129			(1,265,047		)		2,086,557
Common stock issued from exercise of options	25,420		761		—			63,465			—				—				—			—				64,226
Common stock issued from employee stock purchase plan	19,150		575		—			40,353			—				—				—			—				40,928
Foreign currency translation	—		—		—			—			—				—				(185,591		)	—				(185,591		)
Stock based compensation	—		—		—			—			6,432				—				—			—				6,432
Write off discount on stock	—		—		11,161			—			—				—				—			—				11,161
Net income	—		—		—			—			—				1,644,120				—			—				1,644,120
BALANCE, DECEMBER 31, 2002	2,877,891		86,336		—			10,152,729			—				(5,347,723		)		41,538			(1,265,047		)		3,667,833
Common stock issued from exercise of options	224,014		6,720		—			627,126			—				—				—			—				633,846
Common stock issued from employee stock purchase plan	10,993		330		—			52,181			—				—				—			—				52,511
Stock awards	2,000		60		—			20,920			(14,855		)		—							—				6,125
Foreign currency translation	—		—		—			—			—				—				(61,210		)	—				(61,210		)
Tax benefit from exercise of options	—		—		—			104,105			—				—				—			—				104,105
Net income	—		—		—			—			—				3,553,266				—			—				3,553,266
BALANCE, DECEMBER 31, 2003	3,114,898		93,446		—			10,957,061			(14,855		)		(1,794,457		)		(19,672		)	(1,265,047		)		7,956,476
Common stock issued from exercise of options and warrants	52,545		1,577		—			189,103			—				—				—			—				190,680
Common stock issued from employee stock purchase plan	7,666		230		—			59,339			—				—				—			—				59,569
Stock awards	4,000		120		—			43,040			(43,160		)		—							—				—
Stock based compensation	—		—		—			—			24,900				—				—			—				24,900
Foreign currency translation	—		—		—			—							—				(10,246		)	—				(10,246		)
Tax benefit from exercise of options	—		—		—			103,540			—				—				14,752			—				118,292
Net income	—		—		—			—			—				1,594,612				—			—				1,594,612
BALANCE, DECEMBER 31, 2004	3,179,109		$	95,373	$	—		$	11,352,083		$	(33,115	)		$	(199,845	)		$	(15,166	)	$	(1,265,047	)		$	9,934,283

The accompanying notes are an integral part of these consolidated financial statements.

OPTELECOM, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002

1. NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Nature of Business—Optelecom, Inc. (the Company) is a Delaware corporation that was organized in 1972. The Company designs, manufactures and markets video communication products, specializing in transmission and distribution equipment for the delivery of real time video.

Optelecom’s products and services are categorized into two operating segments: the Communication Products Division and the Electro-Optics Technology Division. During 2003 management decided to combine the Copper Products unit and the Optical Products unit into the Communication Products Division in order to manage the business more effectively. The financial results for these operating segments have been prepared on a basis that is consistent with the manner in which Optelecom management internally evaluates financial information for the purpose of assisting in making internal operating decisions. In this regard, certain common expenses have been allocated among segments differently than would be required for stand alone financial information prepared in accordance with accounting principles generally accepted in the United States of America.

Principles of Consolidation—The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries, Optelecom UK Limited (Optelecom UK), and Optelecom Europe Limited. All significant inter-company transactions and balances have been eliminated.

Use of Estimates—The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.

Accounts Receivable—Accounts receivable potentially subject the Company to concentrations of credit risk. Credit is extended based on evaluation of a customer’s financial condition and, generally, collateral is not required. Accounts receivable are due within 30 days and are stated at amounts due from the customers net of an allowance for doubtful accounts. Accounts outstanding longer than the contractual payment terms are considered past due. The Company determines its allowances considering a number of factors, including the length of time trade accounts receivable are past due, the Company’s previous loss history, the customer’s current ability to pay its obligations to the Company, and the condition of the general economy and the industry as a whole. The Company believes that its allowance for doubtful accounts is adequate to cover any potential losses on its credit risk exposure. The Company writes off accounts receivable when they become uncollectible, and payments subsequently received on such receivables are credited to the allowances for doubtful accounts.

Revenue Recognition—Revenue from commercial sales is recognized when products are shipped. Revenues from fixed-price contracts, such as contracts from the government, are recognized on the percentage-of-completion method based on costs incurred in relation to total estimated costs. Revenues from time-and-materials contracts are recorded at the contract rates times the labor hours plus other direct costs as incurred. All shipping handling fees and related costs are recorded as components of cost of goods sold.

Product Warranty—In the ordinary course of business, the Company warrants its products against defect in design, materials, and workmanship over various time periods. Beginning in July 2002 the

Company offers a lifetime warranty on its products. Prior to 2002 the warranty period was limited to four years. Warranty reserve and allowance for product returns is established based upon management’s best estimates of amounts necessary to settle future and existing claims on products sold as of the balance sheet date.

The following is a summary of the Company’s continuing warranty obligation for the years ended December 31:

	2004			2003
Balance, beginning of year	$	60,846		$	44,512
Provision for warranty obligations	152,558			52,446
Charges of warranty obligations	(83,320		)	(36,112		)
Balance, end of year	$	130,084		$	60,846

Inventories—Production materials are valued at the lower of cost or market applied on a weighted average cost basis. Work-in-process represents direct labor, materials, and overhead incurred on products not delivered to date. Finished goods inventories are valued at the lower of cost or market, cost being determined using standards that approximate actual costs on a specific identification basis. Optelecom writes down its inventory for estimated obsolescence or unmarketable inventory based upon assumptions about future demand and market conditions as well as historical inventory turnover. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required.

Property, Equipment, and Depreciation—Property and equipment are recorded at cost and are depreciated using the straight-line method over the estimated useful lives of the assets, which range from 5 to 10 years. Leasehold improvements are amortized over the terms of the respective leases or the service lives of the assets, whichever is shorter. Expenditures for maintenance and repairs are expensed as incurred.

Impairment of Long-Lived Assets—The Company periodically reviews the carrying value of long-lived assets including property and equipment for impairment whenever events or changes in circumstances indicate that the carrying amount of assets may not be recoverable. Recovery of assets to be held and used is measured by comparing the carrying value of these assets with the expected future cash flows generated by the assets. If the assets are considered to be impaired, the impairment is recognized by the amount which the carrying amount of the assets exceeds their fair value. No impairment losses were recorded during 2004, 2003 or 2002.

Research and Development Costs—Research and development costs are expensed as incurred as a component of engineering expense in the consolidated statements of operations. The Company incurred research and development costs of $1,155,000, $979,000 and $847,000 for the years ended December 31, 2004, 2003 and 2002, respectively.

Income Taxes—The Company accounts for income taxes using the asset and liability approach as defined by FASB No. 109, “Accounting for Income Taxes.” Under this method, deferred tax assets and liabilities are determined based on the difference between financial reporting and tax basis of assets and liabilities based on expected tax rates at the point the items are expected to reverse. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized.

Stock-Based Compensation—The Company has elected to follow Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” (APB 25) and related interpretations, in accounting for its employee stock options and complies with the disclosure requirements of SFAS No. 123, “Accounting for Stock-Based Compensation” (FAS 123). APB 25 provides that the compensation expense

relative to the Company’s employee stock options is measured based on the intrinsic value of the stock option. FAS 123 requires companies that continue to follow APB 25 to provide a pro forma disclosure of the impact of applying the fair value method of FAS 123.

In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure (FAS 148). FAS 148 amends FAS 123, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of FAS 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The provisions of this Standard are effective for fiscal years ending after December 15, 2002, and have been incorporated into these financial statements and accompanying footnotes.

Stock-based compensation related to options granted to non-employees is accounted for using the fair value method in accordance with the SFAS No. 123 and EITF 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.

The following table illustrates the effect on net income (loss) and net income (loss) per common share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based compensation.

	2004			2003			2002
Net income as reported	$	1,594,612		$	3,553,266		$	1,644,120
Less: Stock-based employee compensation costs, net of income tax, as if fair value method had been applied	(657,538		)	(279,865		)	(121,052		)
Net income pro forma	$	937,074		$	3,273,401		$	1,523,068
Basic income per share:
As reported	$	0.50		$	1.18		$	0.58
Pro forma	$	0.30		$	1.08		$	0.53
Diluted income per share:
As reported	$	0.49		$	1.11		$	0.56
Pro forma	$	0.29		$	1.02		$	0.52

The effect of applying SFAS No. 123 on a pro forma net loss as stated above is not necessarily representative of the effects on reported net loss for future years due to, among other things, the vesting period of the stock options and the fair value of additional options to be granted in the future years.

The weighted-average fair value of options granted during 2004, 2003, and 2002 was $9.44, $5.89 and $3.15, respectively. The fair value of each option is estimated on the date of grant using the Black Scholes option-pricing model with the following assumptions used for grants issued during the years ended December 31, 2004, 2003, and 2002:

	2004		2003		2002
Expected dividend yield	0	%	0	%	0	%
Expected stock price volatility	87	%	122	%	129	%
Risk-free interest rate	3.60	%	2.27	%	2.39	%
Average expected life	4 years		4 years		4 years

Foreign Currency Translation—The Company translates the assets and liabilities of its foreign subsidiaries into U.S. dollars at the current exchange rate in effect at the end of the year. The gains and losses that result from this process, and gains and losses on inter-company transactions that are long-term in nature and that the Company does not intend to repatriate, are shown in the foreign currency

translation adjustment balance in the stockholder’s equity section of the balance sheet. The revenue and expense accounts of the foreign subsidiaries are translated into U.S. dollars at the average rates that prevailed during the year.

Cash and Cash Equivalents—The Company considers all liquid investments with original maturities of three months or less at the time of purchase to be cash equivalents.

Restricted Certificate of Deposit—The Company has provided a performance bond in relation to a contract which is secured by a letter of credit in the amount of $129,368 at December 31, 2003. This letter of credit was fully collateralized by a certificate of deposit. The certificate of deposit was redeemable by the Company upon the satisfactory completion of the contract in 2004.

Fair Value of Financial Instruments—The carrying amounts of the Company’s financial instruments, which include cash equivalents, trade receivables, accounts payables and accrued expenses, and the revolving credit agreement approximate their fair values due to the short maturities.

Earnings Per Share—Basic earnings per share is computed by dividing net income (loss) by weighted average shares outstanding. No dilution for any potentially dilutive securities is included in basic earnings per share. Diluted earnings per share is computed by dividing net income (loss) by weighted average shares and common equivalent shares outstanding.

The computation of weighted average shares outstanding for the years ended December 31, 2004, 2003 and 2002 is as follows:

	2004		2003		2002
Basic Earnings Per Share:
Earning available to common stockholders	$	1,594,612	$	3,553,266	$	1,644,120
Weighted average common shares outstanding	3,159,285		3,019,279		2,850,587
Basic earnings per share	$	0.50	$	1.18	$	0.58
Diluted Earnings Per Share:
Earning available to common stockholders	$	1,594,612	$	3,553,266	$	1,644,120
Weighted average common shares outstanding	3,159,285		3,019,279		2,850,587
Effect of stock options and warrants	105,522		178,528		89,439
Diluted Shares	3,264,807		3,197,807		2,940,026
Diluted earnings per share	$	0.49	$	1.11	$	0.56

Recent Accounting Pronouncements—In November of 2004, FASB issued Statement No 151, Inventory Costs, an amendment of Accounting Research Bulletin No. 43, Chapter 4 (SFAS 151). The amendments made by SFAS 151 clarify that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current period charges and require the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. The FASB’s goal is to promote convergence of accounting standards internationally by adopting language similar to that used in the International Accounting Standard 2, Inventories adopted by the International Accounting Standards Board (IASB). The Boards noted that the wording of the original standards were similar but were concerned that the differences would lead to inconsistent application of those similar requirements. The guidance is effective for inventory costs incurred during the Company’s year beginning January 1, 2006. The Company does not believe that the adoption of the new standard will have a material impact on its financial position.

approach described in SFAS 123. However, SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. SFAS 123R must be adopted no later than July 1, 2005. Early adoption will be permitted in periods in which financial statements have not yet been issued. The Company expects to adopt SFAS 123R on July 1, 2005.

SFAS 123R permits public companies to adopt its requirement using one of two methods—(i) a “modified prospective” method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of SFAS 123R all share-based payments granted after the effective date and (b) based on the requirements of SFAS 123 for all awards granted to employees prior to the effective date of SFAS 123R that remain unvested on the effective date or (ii) a “modified retrospective” method which includes the requirements of the modified prospective method described above, but also permits entities to restate based on the amounts previously recognized under SFAS 123 for purposes of pro forma disclosures either (a) all prior periods presented or (b) prior interim periods of the year of adoption. The Company is currently evaluating the method it will use when it adopts SFAS 123 R

2. ACCOUNTS AND CONTRACTS RECEIVABLE

Accounts and contracts receivable consisted of the following at December 31:

	2004			2003
Accounts and contracts receivable	$	3,158,782		$	2,937,040
Less: Allowance for doubtful accounts	(143,194		)	(102,084		)
	$	3,015,588		$	2,834,956

3. INVENTORIES

Inventories consisted of the following at December 31:

	2004			2003
Production materials	$	1,604,605		$	1,637,331
Work in process	192,145			414,639
Finished goods	1,164,264			889,022
Allowance for obsolescence	(93,132		)	(279,992		)
Net	$	2,867,882		$	2,661,000

4. PROPERTY AND EQUIPMENT

Property and equipment consisted of the following at December 31:

	2004			2003
Laboratory equipment	$	2,133,285		$	1,695,428
Office equipment	2,092,922			1,998,705
Furniture and fixtures	90,083			83,159
Leasehold improvements	526,890			500,199
Computer hardware and software	402,286			99,806
	5,245,466			4,377,297
Less accumulated depreciation and amortization	(3,375,427		)	(3,026,931		)
Net property and equipment	$	1,870,039		$	1,350,366

Assets under capital leases are included in the above categories and consisted of the following:

	2004			2003
Laboratory equipment	$	85,171		$	85,171
Office equipment	52,389			52,389
	137,560			137,560
Less accumulated amortization	(101,912		)	(92,915		)
Net assets under capital leases	$	35,648		$	44,645

Depreciation expense was $430,180, $332,822 and $360,927 for the years ended December 31, 2004, 2003 and 2002, respectively.

5. INCOME TAXES

The components of income before income taxes consisted of the following for the years ended December 31:

	2004		2003		2002
U.S. Operations	$	2,111,653	$	1,621,094	$	1,909,945
Non-U.S. Operations	178,637		340,895		(249,150		)
	$	2,290,290	$	1,961,989	$	1,660,795

The components of the expense (benefit) provision for income taxes for the years ended December 31 are summarized as follows:

	2004		2003		2002
Current expense (benefit)
U.S. Operations	$	29,299	$	27,153	$	16,675
Non-U.S. Operations	—		—		—
	$	29,299	$	27,153	$	16,675

	2004		2003			2002
Deferred expense (benefit)
U.S. Operations	$	605,189	$	(1,324,455	)	$	—
Non-U.S. Operations	61,190		(293,975		)	—
	$	666,379	$	(1,618,430	)	$	—
Total	$	695,678	$	(1,591,277	)	$	16,675

The difference between the federal income tax expense (benefit) and the amount computed applying the statutory federal income tax rate are summarized as follows for the years ended December 31:

	2004		2003		2002
United States Federal tax at statutory rates	34.0	%	34.0	%	34.0	%
(Reduction) increase of taxes:
State taxes, net of federal benefit	3.3		1.9		3.3
Valuation allowance related to net deferred tax assets	—		(116.8	)	(45.1	)
Income from foreign subsidiary	—		—		7.8
Business tax credits	(6.9	)	—		—
Other	(0.1	)	(0.2	)	(1.1	)
Effective income tax rate	30.3	%	(81.1	)%	(1.1	)%

Deferred income taxes reflect the net tax effects of temporary differences between the amount of assets and liabilities for income tax and financial reporting purposes. The components of deferred income tax liabilities and assets as of December 31 are as follows:

	2004			2003
Gross deferred tax assets:
Excess book depreciation	$	—		$	97,215
Inventory	142,346			199,256
Accrued vacation	76,611			60,329
Deferral of rent expense	68,304			22,898
Bad debt reserve	51,507			41,676
Accrued warranty reserve	47,663			22,294
Tax credits	484,830			311,792
Other	25,924			1,979
Net operating loss—non-US	140,743			191,818
Net operating loss	338,008			779,006
Deferred tax assets	1,375,936			1,728,263
Gross deferred tax liabilities:
Excess tax depreciation	(134,394		)	—
Other	(67,093		)	—
Net deferred tax assets	$	1,174,449		$	1,728,263

As of December 31, 2004, Optelecom had tax effected net operating loss and business tax credit carryforwards of approximately $338,000 and $425,000, respectively, for US income tax purposes. These carryforwards begin to expire in the year 2020. The Company also had tax credit carryforwards available for alternative minimum tax purposes of approximately $45,000, which do not expire. The use of these net operating loss and tax credit carryforwards may be subject to limitation under the rules regarding a change of ownership as determined by the Internal Revenue Service. The effects of potential ownership changes, if any, have not been analyzed by the Company. Additionally, as of December 31, 2004, Optelecom had tax effected net operating loss carryforwards in jurisdictions outside the United States of approximately $141,000, which carry forward indefinitely.

In evaluating the Company’s ability to recover its deferred tax assets, we considered all available positive and negative evidence, including past operating results, the reversal of temporary differences, the forecasts of future taxable income and the implementation of feasible and prudent tax planning strategies. These assumptions require significant judgment about the forecasts of future taxable income and are consistent with estimates being used to manage the business. Based on the weight of the positive and negative evidence and the information available, Optelecom believes that it is more likely than not that its deferred tax assets will be realized.

6. NOTES PAYABLE TO BANK

Under its current banking facility, the Company has the ability to borrow up to $3.5 million under its existing bank line-of-credit as of December 31, 2004, provided there are sufficient accounts receivable and inventory,. This facility consists of two components: (a) a demand working capital line of credit which will enable the Company to borrow up to the lesser of $3.0 million or the borrowing base; and (b) a $500,000 transaction specific revolving demand export line of credit for short-term financing. The amount available will be the lesser of $500,000 or the borrowing base. The Company’s borrowing base under the first facility equals the sum of 90% of eligible government billed accounts receivable, 80% of the eligible commercial billed accounts receivable and 20% of eligible related inventory capped at $500,000. The Company’s borrowing base under the second facility equals the sum of 75% of the eligible export-related inventory and 90% of the eligible export-related accounts receivable. This facility is guaranteed 90% by the Export-Import Bank of the United States (“Ex-Im Bank”) under Ex-Im Bank’s Working Capital Guarantee Program.

The Company had a promissory note agreement with a bank that was collateralized by substantially all the assets and contracts of the Company. The original note principal was $2,500,000 and was payable in monthly installments of $62,500 through August 2002, with interest payable monthly at the rate of prime plus 1%. The principal balance was repaid during 2002.

The Company took delivery of major capital equipment for its manufacturing operations in March 2003 and incurred a promissory note with the vendor. The note principal was $180,000 and is payable in semi-annual installments of $22,500 beginning June 2003 through December 2006, with interest payable at the rate of 4.40%.

On March 8, 2005, in connection with the Company’s acquisition of NKF Electronics the Company executed acquisition related debt agreements which are described in Note 11.

7. COMMITMENTS AND CONTINGENCIES

Operating Leases—In March 2003, the Company began to occupy its corporate office and manufacturing facility located in Germantown, Maryland. As an inducement to enter this operating lease, the Company received certain incentives such as rent abatement. Additionally, the lease provides for scheduled rent increases. These lease incentives will be amortized over the lease period. Rent expense is being recognized on a straight-line basis.

Optelecom Europe, Ltd. has leases for office and sales facilities, which expire in June, 2006.

As of December 31, 2004, future net minimum rental payments required under operating leases that have initial or remaining non-cancelable terms in excess of one year are as follows:

Year Ended December 31:
2005	$	519,031
2006	512,105
2007	511,024
2008	525,617
2009	541,383
Thereafter	2,129,268
	$4,738,428

Rent expense was $565,733, $530,478 and $263,642 in 2004, 2003 and 2002, respectively.

During 2004 and 2003, Optelecom leased office and laboratory equipment and a motor vehicle. These leases have terms ranging from one to five years and were recorded as operating and capital leases. The future minimum payments under these leases are $28,892.

Legal Proceedings—From time to time, Optelecom is involved in legal proceedings and litigation arising in the ordinary course of business. As of the date of this report Optelecom is not a party to any litigation or other legal proceeding that, in the opinion of management, could have a material adverse effect on our business, financial condition or results of operations.

8. STOCKHOLDERS’ EQUITY

Common Stock—During 2003 and 2004, proceeds from the exercise of stock options were $633,847 and $294,220, respectively.

Director’s Stock Compensation—Each non-employee Director receives stock options to purchase 1,000 shares of common stock for each board meeting attended either in person or by telephone. Additionally, each non-employee Director is granted 1,000 shares of restricted common stock at the closing price on the date of the annual shareholders’ meeting.

Stock Options—The 2000 Nonqualified Employee Stock Option Plan was terminated and rolled into the 2002 Incentive Stock Option Plan. The Company issued 23,400 options under the 2000 Plan. The exercise price of each option was the fair market value of the stock at the grant date. Options are exercisable after one year from the date of grant and in equal increments over four years. Options expire five years from the date of grant and, in most cases, upon termination of employment.

The 2002 Incentive Stock Option Plan provides for up to 476,600 shares available for grant. The options may be granted to officers (including officers who are directors), other key employees of, and consultants to the Company. There were 205,308 options available for future grant at December 31, 2004. The exercise price of each option is the fair market value of the stock at the grant date. Options are 25% exercisable at the grant date, 75% exercisable one year from the grant date and fully exercisable two years

from the grant date. Options expire five years from the date of grant and, in most cases, upon termination of employment.

A summary of stock option activity for the Non-qualified Employee and Incentive Stock Option Plans during the years ended December 31 is as follows:

	2004				2003				2002
		Weighted				Weighted				Weighted
		Average				Average				Average
		Exercise				Exercise				Exercise
	Shares	Price			Shares	Price			Shares	Price
Outstanding, January 1	187,550		$	4.51	164,938		$	3.72	176,801		$	4.37
Granted	138,091		9.35		103,851		5.30		39,700		3.95
Exercised	33,295		3.74		72,764		3.73		16,169		2.36
Canceled	612		2.93		8,475		5.45		35,394		7.79
Outstanding, end of year	291,734		$	6.89	187,550		$	4.51	164,938		$	3.72
Exercisable options, December 31	148,786		$	5.86	72,915		$	4.31	82,971		$	4.05

The following table summarizes information about stock options outstanding at December 31, 2004:

	Options Outstanding							Options Exercisable
			Weighted		Weighted					Weighted
			average		average					average
	Number		remaining		exercise			Number		exercise
Range of exercise price	outstanding		life in years		price			exercisable		price
$1.44 to $4.66		119,768		2.45		$	3.89		83,608		$	3.91
$4.77 to $9.17		28,875		2.25		6.01			24,800		5.70
$9.19 to $9.19		118,166		4.02		9.19			28,928		9.19
$9.22 and above		24,925		3.86		11.45			11,450		12.00
		291,734		3.19		$	6.89		148,786		$	5.86

The 2001 Nonqualified Director Stock Option Plan provides for up to 200,000 shares available for grant. Under this plan, each non-employee director who attends a Board of Directors meeting is granted an option to purchase 1,000 shares of common stock at fair market value on the date of such Board meeting. The options are exercisable upon grant and expire five years thereafter. There were 110,500 options available for future grant at December 31, 2004.

A summary of stock option activity for the Non-qualified Director Plan during the year ended December 31 is as follows:

	2004				2003				2002
	Shares	Weighted Average Exercise Price			Shares	Weighted Average Exercise Price			Shares	Weighted Average Exercise Price
Outstanding, January 1	55,500		$	6.14	91,250		$	3.85	83,000		$	3.68
Granted	34,000		9.78		15,500		9.81		17,000		3.74
Exercised	19,250		3.43		51,250		3.18		8,750		2.98
Canceled	—		—		—		—		—		—
Outstanding, end of year	70,250		$	8.65	55,500		$	6.14	91,250		$	3.85
Exercisable options, December 31	70,250		$	8.65	55,500		$	6.14	91,250		$	3.85

The following table summarizes information about stock options outstanding at December 31, 2004:

	Options Outstanding							Options Exercisable
Range of exercise price	Number outstanding		Weighted average remaining life in years		Weighted average exercise price			Number exercisable		Weighted average exercise price
$1.75 to $5.23		18,250		1.51		$	3.49		18,250		$	3.49
$5.87 to $9.20		19,500		4.30		8.72			19,500		8.72
$9.71 to $10.79		19,000		4.16		10.25			19,000		10.25
$10.82 and above		13,500		2.68		13.25			13,500		13.25
		70,250		3.23		$	8.65		70,250		$	8.65

9. EMPLOYEE BENEFIT PLANS

The Company has a noncontributory Profit-Sharing Retirement Plan covering substantially all employees. Vesting occurs over a period of four years from the date of entry into the plan (date of employment). Under the plan, the Company’s contribution is determined annually by the Board of Directors and is funded as accrued. There was no profit-sharing expense for 2004, 2003 and 2002.

The Company also has a contributory cash and deferred profit sharing plan qualified under Section 401(k) of the Internal Revenue Code for all of the Company’s full-time employees. The Company matches employee contributions to the plan up to a maximum of 2.5%. Total matching contributions were $111,241, $84,318 and $59,036 in 2004, 2003 and 2002, respectively.

10. BUSINESS SEGMENT INFORMATION

Description of the Types of Products from which each Segment Derives its Revenues

The Company manages its operations in two segments: the Communication Products Division which develops, manufactures, and sells optical fiber-based data communication equipment to both commercial and government clients, and the Electro-Optics Division which is focused on Interferometric Fiber Optic Gyro coils.

Measurement of Segment Profit of Loss and Segment Assets

The Company evaluates performance and allocates resources based on profit or loss from operations before income taxes. The accounting policies of the reportable segments are the same as described in the summary of significant accounting policies. Inter-segment sales at current market prices.

Factors Management Used to Identify the Company’s Reportable Segments

The Company’s reportable segments are business units that manufacture and market separate and distinct products and are managed separately because each business requires different processes, technologies, and market strategies. The following table summarizes revenues, depreciation and amortization, operating income, total assets, and capital expenditures by business segment for fiscal 2004, 2003, and 2002:

	Year ended December 31, 2004
	Communication Products Division			Electro- Optics Division		Total
Revenues		$	17,952,579	$	1,442,568	$	19,395,147
Depreciation and amortization		430,180		—		430,180
Income from operations		1,930,645		339,330		2,269,975
Assets		12,157,605		208,804		12,366,409
Capital expenditures		948,363		—		948,363

	Year ended December 31, 2003
	Communication Products Division			Electro- Optics Division		Total
Revenues		$	15,327,411	$	1,792,247	$	17,119,658
Depreciation and amortization		332,822		—		332,822
Income from operations		1,427,838		544,497		1,972,335
Assets		10,125,473		306,424		10,431,897
Capital expenditures		1,160,205		—		1,160,205

	Year ended December 31, 2002
	Communication Products Division			Electro- Optics Division		Total
Revenues		$	13,665,771	$	1,242,783	$	14,908,554
Depreciation and amortization		360,927		—		360,927
Income from operations		1,235,680		376,439		1,612,119
Assets		6,312,719		314,504		6,627,223
Capital expenditures		123,510		—		123,510

Reconciliation of operating profit by segment to net income before benefit (provision) for income taxes:

	2004			2003			2002
Operating income (loss) by segment	$	2,269,975		$	1,972,335		$	1,612,119
Interest expense—line of credit	—			(11,483		)	(77,442		)
Interest expense—long term notes	(5,445		)	(3,465		)	(13,422		)
Other income (expense)	25,760			4,602			139,540
Total other income (expense)	20,315			(10,346		)	48,676
Income (loss) before provision for income taxes	$	2,290,290		$	1,961,989		$	1,660,795

Optelecom is engaged primarily in the development, manufacture, and sale of optical fiber communications products and laser systems. Revenue represents shipments and services provided to third parties. Contract costs and operating expenses directly traceable to individual segments were deducted

from revenue to arrive at operating income. Identifiable assets by segment are those assets that are used in the Company’s operations in each segment.

Significant Customers and Foreign Exports

Optelecom does most of its business with commercial customers with some sales to the U.S. Government and its prime contractors. In 2004, five commercial customers accounted for a total of 21% of sales with no one customer accounting for more than 10% of sales. In 2003, five commercial customers accounted for a total of 21% of sales with no one customer accounting for more than 10% of sales. In 2002, five commercial customers accounted for a total of 22% of sales with one customer accounting for more than 10% of sales.

Included in the Communication Products’ revenues are export sales of $1,709,360, $1,462,967 and $3,260,000 for 2004, 2003, and 2002, respectively. Additionally, the Communication Products Division has operations in Europe through its Optelecom Europe, Ltd. subsidiary and it recorded sales of $2,688,221, $3,224,158 and $1,881,219 for 2004, 2003 and 2002, respectively. Long-lived assets reported for the Optelecom Europe, Ltd. are located in the United Kingdom. All long-lived assets for the Communication Products segment are located in the United States.

11. SUBSEQUENT EVENT

On March 8, 2005, Optelecom, Inc. (the “Company”) completed the acquisition of NKF Electronics, B.V. a private company with limited liability, incorporated in the Netherlands (“NKF”), pursuant to the terms and conditions of the Share Purchase Agreement dated March 8, 2005 (the “Purchase Agreement”)

Pursuant to the Purchase Agreement, the Company acquired all of the outstanding stock of NKF for the following consideration (the “Acquisition Consideration”): (a) eleven million Euro (€11,000,000) paid in cash; and (b) a Subordinated Promissory Note in the principal amount of up to Nine Million Euro (€9,000,000) (the “Subordinated Note”), subject to final purchase price adjustments. The Subordinated Note accrues interest at a rate of 6% per annum and is due and payable in full on March 8, 2010. The Acquisition Consideration is subject to post-closing adjustment in accordance with the terms and conditions of the Purchase Agreement. The amount of consideration was determined on the basis of arm’s length negotiations between the Company and Draka.

12. QUARTERLY INFORMATION (UNAUDITED)

The following unaudited information sets forth our results of operations on a quarterly basis for the two years ended December 31, 2004 and 2003:

	March 31			June 30		September 30			December 31
	(amounts in thousands except per share data)
2004:
Revenues, net		$	4,180	$	4,265		$	5,530		$	5,420
Gross profit		2,411		2,433			3,143			3,141
Operating income		441		449			755			625
Net income		303		303			569			420
Earnings per share—basic		$	0.10	$	0.10		$	0.18		$	0.13
Earnings per share—diluted		$	0.09	$	0.09		$	0.17		$	0.13
2003:
Revenues, net		$	3,488	$	4,176		$	4,499		$	4,957
Gross profit		1,966		2,490			2,507			2,320
Operating income		376		544			660			392
Net income		369		536			645			2,003
Earnings per share—basic		$	0.13	$	0.18		$	0.21		$	0.64
Earnings per share—diluted		$	0.12	$	0.17		$	0.20		$	0.62

Item 9. CHANGES IN AND DISAGREEMENT WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None

Item 9A. CONTROLS AND PROCEDURES

Under the direction and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, the Company carried out an evaluation of the effectiveness of the design and operation of its disclosure controls and procedures pursuant to Exchange Act Rule 13a-15 as of the end of the period covered by the report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act of 1934 (i) is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and (ii) is accumulated and communicated to the Company’s senior management to allow timely decisions regarding required disclosure.

There have been no significant changes in our internal controls over financial reporting or, to our knowledge, in other factors that could significantly affect our internal control over financial reporting subsequent to the date we conducted the above-described evaluation. The Company is currently reviewing the new internal controls documentation and attestation requirements regarding Rule 404 of the Sarbanes Oxley Act of 2002 and is confident that it will fully comply with such requirements.

PART III

Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The information called for by this Item regarding directors and executive officers is set forth in the Company’s Proxy Statement for the 2005 Annual Meeting in the Sections entitled “Election of Directors,” “Management” and “Section 16(a) Beneficial Ownership Reporting Compliance” and is incorporated herein by reference.

		Page
Report of Independent Registered Public Accounting Firm		25
Independent Auditors Report		26
Consolidated Balance Sheets as of December 31, 2004 and 2003		27
Consolidated Statements of Operations for the years ended December 31, 2004, 2003 and 2002		28
Consolidated Statements of Cash Flows for the years ended December 31, 2004, 2003 and 2002		29
Consolidated Statements of Stockholders’ Equity for the years ended December 31, 2004, 2003 and 2002		30
Notes to Consolidated Financial Statements		31
SCHEDULE OF VALUATION AND QUALIFYING ACCOUNTS		48

	2004			2003
ASSETS
CURRENT ASSETS
Cash and cash equivalents	$	2,918,959		$	1,387,866
Accounts and contracts receivable, net	3,015,588			2,834,956
Inventories, net	2,867,882			2,661,000
Deferred tax asset—current	767,841			1,069,479
Prepaid expenses and other current assets	519,494			340,078
Total current assets	10,089,764			8,293,379
Property and equipment, net	1,870,039			1,350,366
Restricted certificate of deposit	—			129,368
Deferred tax asset—non-current	406,606			658,784
TOTAL ASSETS	$	12,366,409		$	10,431,897
LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES
Accounts payable	$	798,965		$	1,052,410
Accrued payroll	394,185			315,889
Commissions payable	297,870			287,767
Current portion of notes payable	45,000			67,500
Accrued warranty reserve	130,084			60,846
Other current liabilities	523,078			526,989
Total current liabilities	2,189,182			2,311,401
Notes payable	45,000			90,000
Security deposits payable	11,526			11,526
Deferred rent liability	186,418			62,494
Total liabilities	2,432,126			2,475,421
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS’ EQUITY:
Common stock, $.03 par value—shares authorized, 15,000,000; issued and outstanding, 3,179,109 and 3,114,898 shares as of 2004 and 2003, respectively	95,373			93,446
Additional paid-in capital	11,318,968			10,942,206
Other comprehensive income	(15,166		)	(19,672		)
Treasury stock, 162,672 shares, at cost	(1,265,047		)	(1,265,047		)
Accumulated deficit	(199,845		)	(1,794,457		)
Total stockholders’ equity	9,934,283			7,956,476
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	12,366,409		$	10,431,897

Number	Description
(a)	The following documents are filed as a part of this report:
(1)	All financial statements;
	The consolidated financial statements of the Company and its subsidiaries on pages 27 through 30 hereof, and the reports thereon of Grant Thornton LLP and Ernst & Young LLP appearing on pages 25 and 26 hereof.
(2)	Financial Statement Schedule
	Schedule II for the years ended December 31, 2004, 2003 and 2002 and the report thereon of Grant Thornton LLP and Ernst & Young LLP appearing on pages 25 and 26 hereof. All other schedules have been omitted because they are not applicable or are not required. All other required schedules are included in the Consolidated Financial Statements or notes therein.
(3)	Exhibits
	3.1	Certificate of Incorporation, as amended (Incorporated by reference from Form 10-K filed March 31, 1998)
	3.2	By-Laws (Incorporated by reference from Form 10-K filed March 31, 1998)
	21	List of Subsidiaries
	23.1	Consent of Grant Thornton LLP—Independent Certified Public Accountants
	23.2	Consent of Ernst & Young LLP—Independent Certified Public Accountants

	31.1	Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
	31.2	Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
	32	Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
(b)	Reports on Form 8-K:
	None

	OPTELECOM, INC.
Date: March 24, 2005	By	/s/ EDMUND LUDWIG
		Edmund Ludwig
		Director and President and CEO

Item	Description	Page Number
PART I
Item 1	Business	3
Item 1A	Risk Factors	8
Item 2	Properties	11
Item 3	Legal Proceedings	11
Item 4	Submission of Matters to a Vote of Security Holders	11
PART II
Item 5	Market for Registrant’s Common Stock and Related Stockholder Matters	12
Item 6	Selected Consolidated Financial Data	13
Item 7	Management’s Discussion and Analysis of Financial Condition and Results of Operations	14
Item 7A	Qualitative and Quantitative Disclosures About Market Risk	23
Item 8	Financial Statements and Supplementary Data	24
Item 9	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	44
Item 9a	Controls and Procedures	44
PART III
Item 10	Directors and Executive Officers of the Registrant	44
Item 11	Executive Compensation	45
Item 12	Security Ownership of Certain Beneficial Owners and Management	45
Item 13	Certain Relationships and Related Transactions	45
Item 14	Principal Accounting Fees and Services	45
PART IV
Item 15	Exhibits, Financial Statement Schedules and Reports on Form 8-K	45
Signatures		47

	OPTELECOM, INC.
Date: March 24, 2005	By	/s/ CARL RUBBO, JR.
		Carl Rubbo, Jr.
		Director
Date: March 24, 2005	By	/s/ DAVID R. LIPINSKI
		David R. Lipinski
		Director
Date: March 24, 2005	By	/s/ ROBERT URSO
		Robert Urso
		Director
Date: March 24, 2005	By	/s/ WALTER R. FATZINGER, JR.
		Walter R. Fatzinger, Jr.
		Director
Date: March 24, 2005	By	/s/ JAMES ARMSTRONG
		James Armstrong
		Director and Chief Financial Officer

	Balance at		Charged to					Balance
	Beginning of Period		Costs and Expenses		Deductions			at End of Period
Year Ended December 31, 2004:
Reserves and allowances deducted from asset accounts:
Obsolescence reserve for inventory	$	279,991	$	120,079	$	(306,938	)	$	93,132
Allowance for uncollectible accounts receivable	102,084		41,111		—			143,195
Valuation allowance for deferred tax assets	—		—		—			—
Year Ended December 31, 2003:
Reserves and allowances deducted from asset accounts:
Obsolescence reserve for inventory	303,996		266,412		(290,417		)	279,991
Allowance for uncollectible accounts receivable	156,439		77,350		(131,705		)	102,084
Valuation allowance for deferred tax assets	1,449,630		—		(1,449,630		)	—
Year Ended December 31, 2002:
Reserves and allowances deducted from asset accounts:
Obsolescence reserve for inventory	352,700		150,434		(199,138		)	303,996
Allowance for uncollectible accounts receivable	101,742		104,481		(49,784		)	156,439
Valuation allowance for deferred tax assets	2,760,817		—		(1,311,187		)	1,449,630